Should You Sell Caterpillar After Its 20% Gain?

| About: Caterpillar Inc. (CAT)

Summary

Shares in Caterpillar have risen this year despite the company facing continued challenges, which may lead to its investors considering profit-taking.

However, we think that its restructuring and investment in new products could positively catalyse its earnings and share price.

Further, Caterpillar is set to benefit from a loose monetary policy, while its valuation also indicates that now is a time to buy it.

Since the turn of the year, shares in Caterpillar (NYSE: CAT) have risen by over 20%. This easily beats the S&P 500's gain of 6% during the same time period, but some investors may now feel that taking a profit is a wise move. After all, Caterpillar is still in the middle of a major restructuring and remains heavily dependent upon commodity prices, due to its reliance on resources companies for over 48% of its sales.

However, we think that now is not the right time to sell Caterpillar. Rather, we think it is an opportune moment to buy it and we believe that these three catalysts will push its share price higher moving forward and allow it to keep beating the wider index.

As mentioned, Caterpillar is undergoing a major restructuring at the present time and we feel that this will have a positive impact on its earnings and share price. That's because we believe that after the changes being made, Caterpillar will emerge as a leaner, more efficient and ultimately more profitable business which is more adaptable and nimble in a fast-changing world.

For example, Caterpillar is making additional workforce reductions on top of those previously announced prior to its Q2 update. While this will increase restructuring costs by around $150 million to $700 million, we feel that this will further enhance the company's ability to ride out the current downturn.

With Caterpillar set to reduce its workforce by over 10,000 by 2018, the company's costs should fall significantly and with other cost cutting measures such as reducing its manufacturing square footage by 10% contributing to around $1.5 billion in cost reductions, we think that Caterpillar's financial performance will be given a boost by its ambitious restructuring programme. In our view, this improved outlook for its cost base could improve investor sentiment and positively catalyse Caterpillar's share price moving forward.

As well as becoming leaner and more efficient, Caterpillar is also investing heavily in new products. In our view, this will be a second catalyst on its earnings and share price moving forward, with Caterpillar maintaining its R&D spending throughout the current downturn. For example, the company is investing heavily in digital solutions in order to improve productivity, safety, efficiency and profitability for its customers, while its hybrid microgrids solutions provide long-term growth potential due to increasing demand for sustainable energy solutions.

In tandem with new product development is Caterpillar's investment in Lean manufacturing. This has reduced internal defects in the company's products by 95% and also improved warranty performance. It has also boosted the company's efficiency and productivity and, alongside its investment in new products, shows that Caterpillar continues to have a sound growth strategy. In our view, this strategy of investing heavily in its business during a downturn has the potential to boost its profitability and positively catalyse its share price moving forward.

A third catalyst to push Caterpillar's earnings and share price higher is the outlook for US interest rates. The Federal Reserve is now expected to raise rates by just 25 basis points in the next year and while the US dollar is expected to strengthen against a basket of major currencies over the same time period, the amount by which it is expected to strengthen is now less than it was six months ago. In other words, while the US dollar is set to strengthen and cause a negative currency effect on Caterpillar's international earnings, the amount is likely to be less than had been anticipated by investors.

Further, with interest rates now set to stay low for longer, Caterpillar's US construction-focused business is likely to gain a boost. With it making up around 35% of Caterpillar's sales, construction remains a key part of the business and an accommodative monetary policy could act as a further positive catalyst on Caterpillar's earnings and share price moving forward.

Sure, Caterpillar is a relatively risky play. It remains highly susceptible to commodity prices and while they have stabilized in recent months, they have done so at a relatively low level. And with the global economic outlook being uncertain, further price falls cannot be ruled out over the near or long term. Further, with Caterpillar undergoing a major restructuring, there is a risk that costs will continue to rise (as they did in Q2) and that the changes being made to the business will take longer than anticipated to have their desired effects.

However, with Caterpillar having a P/S (price-to-sales) ratio of just 1.16, as well as an EV/Sales ratio of just 1.94, we think that those risks are more than adequately priced in. And with its restructuring, product innovation and investment, as well as a loose monetary policy having the potential to act as positive catalysts on its share price moving forward, we feel that now is the time to buy rather than sell Caterpillar.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.